Monday, January 12, 2015

Updated February 3, 2015A speech by Jeremy Stein,
former Governor of the Federal Reserve Bank of St. Louis looks positively
prescient, particularly as interest rates appear to be heading up and the price
of oil has fallen substantially.

He notes that there are
three factors that can contribute to "overheating" as follows:

1.) Financial innovation:
While financial innovation has provided benefits to the economy, it can lead to
the creation of new financial products that do not fall under any sort of
regulation since the regulators tend to act well behind the changes in
industry. A prime example of this is the existence of second-generation
securities like the subprime CDOs that came into existence during the housing
boom. As we all know, it was the collapse in the value of these
imaginative new derivatives that nearly caused the world's economy to implode.
The financial industry is guilty of making decisions on their own behalf
that maximize their profits and compensation and, in the competitive nature of
Wall Street, these decisions are made solely to attract new money and increase
the assets that are under management.

2.) Regulation: As new
regulations are implemented, they tend to open new regulatory loopholes which
spur the development of new products, once again, in an attempt to maximize
profits and compensation.

"The third factor
that can lead to overheating is a change in the economic environment that
alters the risk-taking incentives of agents making credit decisions. For
example, a prolonged period of low interest rates, of the sort we are
experiencing today, can create incentives for agents to take on greater
duration or credit risks, or to employ additional financial leverage, in an
effort to "reach for yield." An insurance company that has
offered guaranteed minimum rates of return on some of its products might find
its solvency threatened by a long stretch of low rates and feel compelled to
take on added risk. A similar logic applies to a bank whose net
interest margins are under pressure because low rates erode the profitability
of its deposit-taking franchise. "

Hold your thoughts on
that one for a moment.

Mr. Stein goes on to note
that all three of these factors can interact with each other and gives the
example of a low interest rate environment that increases the demand for the
financial industry to engage in "below-the-radar forms of
risk-taking". He notes that the high demand for high-yield (i.e.
junk bonds) is part of investors "reaching-for-yield" in this low
interest rate environment, an issue that could result in significant losses to
junk bond investors.

In Thomson Reuters latest
Debt Capital Markets Review, they note that
global high-yield corporate debt issuance fell over the last two quarters but
was still just below the record of $442.5 billion set in 2013 at $441.5 billion
as shown on this bar graph:

Nonetheless, as the graph
shows, since 2009, the issuance of corporate junk bonds has mushroomed since
the end of the Great Recession, particularly when we compare the total dollar
value issued between 2009 and 2014 to the value issued in 2006 and 2007.
This is thanks to two factors:

1.) companies that are
less creditworthy are able to raise funds at relatively low rates compared to
the past because of the global low interest rate environment as shown on this graph:

You'll note that the drop
off in junk bond issuance pretty much parallels the increase in interest rates
from below 8 percent in June 2014 to the current rate of 11.46 percent.
You will also observe that the spread between junk bonds and Treasuries
was at a multi-year low in mid-2014 as shown on this graph:

2.) investors are
"reaching-for-yield" because of the prolonged period of near-zero
interest rates on Treasuries and other fixed income investments.

Fortunately, for those of
us that are non-professional investors, FINRA provides a bond market pricing
and yield tool. From their website, we can see what has happened to the price of high yield bonds over the past year
(and I apologize for the quality of the screen capture in advance):

Now, let's put the recent
collapse of the price of oil into this equation and see what has happened to
the price and yield of some oil sector bonds, including a sample of bonds issued by smaller oil
shale players, over the past year, noting that the current yield is well above the coupon interest rate:

I think that's enough information to give you a general idea of the problem. The debt of smaller oil companies exploiting shale oil reserves in
North America and those that are viewed as weaker players is getting hammered. Not only will it be difficult for these companies to raise money at these high interest rates, their low share prices will make it difficult to issue additional equity to fund their ongoing operations.

According to Citi
Research, the energy sector accounts for 17.4
percent of the high-yield bond market, up from 12 percent in 2002.
Smaller oil companies involved in the high-cost high-decline fracking
plays rely on debt to fund their operations, however, in this low price
environment, it will be increasingly difficult for them to rely on cash flow to
fund further operations because of low prices and high production decline rates
and an inability to raise additional capital through the issuance of new debt
unless they are willing to pay bondholders substantially higher interest rates.

When we combine what is
currently happening in the world's oil market, the high-yield energy bond
market and Mr. Stein's observations about "overheating in the credit market", it is
apparent that the Federal Reserve's prolonged policy of near-zero interest
rates is coming apart at the seams. Unfortunately, as was the case in 2008 - 2009, it is the small retail investor that will pay the biggest price for the Fed's mistake.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.